Do credit rating agencies help or hurt?

Dr Damien King, head of the Department of Economics, University of the West Indies.

Dr Damien King reckons that credit rating agencies can determine when countries default on their foreign currency debt. Well, at least for poor countries.

The University of the West Indies (UWI) economics lecturer said that his latest research paper proves that international credit ratings are biased against low-income countries. Perhaps more importantly, the rating agencies influence whether a country decides to service its debt.

"We found that there is a range of debt where if the credit rating agency gives a poor rating, then it makes sense to default, and if they give a good rating, then it doesn't make sense to default," said King in his presentation at a seminar called Financing Development in Jamaica held at the UWI regional headquarters in Mona on April 21.

"In that band of ambiguity, the credit rating agency determines whether a country defaults or not."

His research team, which includes Professor David Tennant and Marlon Tracey, both from UWI's Economics Department, argues that credit rating agencies have good reason to be biased against poor countries in a paper titled Are the International Credit Rating Agencies Unwittingly Our Foes?.

"It is costly to acquire the necessary information to arrive at a fair assessment of a poor country's ability and willingness to service its debt," King explained.

That's because the same considerations that tend to make them poor also reduces their ability to produce readily available, good information about their finances.

"We argue that to rate a country highly and then it defaults, is worse for the credit rating agency's reputation than the other way around, mainly because that kind of mistake makes the news," he said. "Countries that get poor ratings and go on to service their debt year after year don't make the news."

Put another way, the lowest cost to a rating agency is achieved by simply over-estimating a country's likelihood to default.

Evidence from data across 142 countries dating from 1997 to 2011 as well as information from the 'Big Three' - Moody's, Standard and Poor's (S&P), and Fitch - support their argument.

Empirical analysis of the data showed that low-income countries have to meet higher standards to get a ratings upgrade. This was true for all three ratings agencies, with S&P having the lowest threshold for poor countries, albeit clearly higher than for rich countries, and Fitch requiring the tallest leap for these countries to get a favourable change in their ratings.

"When does it suit a government to default and restructure?" King asked rhetorically. "There is a fixed cost of defaulting. Government is not going to default unless it is worth it. The credit rating agencies' ratings will reflect when it is better for a government to default," he said.